Founded in 1993 by brothers Tom and David Gardner, The Motley Fool helps millions of people attain financial freedom through our website, podcasts, books, newspaper column, radio show, and premium investing services.

When to Double Down

Floundering stocks are sometimes opportunities in disguise.

Here's a very short story that demonstrates one of the great principles of winning investing:

New York Yankees relief pitcher Mariano Rivera got off to a bad start in the 2005 season. In the first two games, he gave up five hits and six runs to the rival Boston Red Sox. Yes, something seemed wrong with the man many believe to be the greatest reliever ever.

Seemingly human, he suddenly became trade bait in my fantasy league. I knew, however, that he was still a great pitcher, and I offered up the solid but unspectacular Troy Percival in return. The deal was done. I'd just purchased an all-star for a bargain price -- and Rivera did me proud by having another spectacular season and winning Reliever of the Year honors (yet again).

How to find your own RiveraIt's an easy-to-understand yet powerful lesson. Sometimes, good companies will take an undeserved hit, leaving you with an opportunity to buy in at bargain prices.

For example, Tom Gardner recommended Silicon Labs to Motley Fool Stock Advisor members in August 2004. A couple of months later, the integrated-circuits designer was down 6%, and Tom recommended it again. After three more months, it was down more than 15%. What did Tom do? He picked it a third time.

At one point, Silicon Labs was down more than 25% from the original recommendation. A quarter of the company's value had vanished. Was Tom worried? Well, probably, but nothing had changed his mind about the business prospects -- Rivera was still Rivera, after all -- so he continued to back the stock.

The three-step modelTom was comfortable recommending this company three times, because it fit beautifully into the following three-layer mold:

An out-of-favor company with fixable problems in a beaten-down, relevant industry.

A strong balance sheet.

Significant insider ownership.

Stocks with this profile are often representative of solid companies with great turnaround potential. Sooner or later, a relevant industry will reverse course and head north again; businesses with strong balance sheets will survive to see that day. Meanwhile, managers with a large stake in their business add to the probability of success, because they have heavy incentives to increase shareholder value.

Back to the SLABWhen Tom first recommended it, Silicon Labs was off some 40% from its recent highs for a few reasons; among them were misguided concerns about its inventory picture and the bloodbath in the semiconductor industry, whose index was down more than 70% from its 2000 high. The carnage was broad-based, taking down big names such as Intel, STMicroelectronics(NYSE:STM), Infineon(NYSE:IFX), Micron Technology(NYSE:MU), and KLA-Tencor(NASDAQ:KLAC).

Eventually, things would get better for the industry. Fast, efficient chips were appearing in more and more products, a trend that would continue to rocket ahead. Silicon Labs -- whose largest customers include Intel and Apple(NASDAQ:AAPL) -- would not be left behind.

The balance sheet was strong: $215 million in cash, no debt, and receivables in line with sales. Those worried about an inventory increase didn't understand that there was actually a positive inventory divergence, with a rapid buildup in raw materials and a burndown in finished goods.

The icing on the cake was that the chairman and two other co-founders owned a large percentage of the stock. Tom knew the trio would strive for operational excellence.

The dust settles ...Tom isn't perfect. He has sold some companies -- Hypercom(NYSE:HYC) comes to mind -- and watched them rise in value afterward. But he was right about Silicon Labs, because the stock fit the three-step model. And the price sure did rebound with a fury.

Today, Silicon Labs' stock is suffering once again. The broad-based market carnage has sent the price down 45% from recent highs. And although Tom's three-pick average is back in positive territory, he is advising those wanting to add new money to wait for better prices.

I don't want to oversimplify things; there were many other factors in Tom's selection of Silicon Labs (and all of his recommendations), but the three points above led him down the right path. Silicon Labs is just one of the reasons his recommendations have a total average return of 76% since the Stock Advisor service began in 2002. David Gardner is also doing well with 70% average returns, while equal amounts invested in the S&P 500 would have returned 30%. A 30-day free trial will give you full access to each and every issue of Stock Advisor -- as well as all of the Gardner brothers' formal recommendations. Click here for more information.

This article was originally published Feb. 2, 2006. It has been updated.

Rex Moore certifies that no keyboards were harmed in the writing of this story. He owns no companies mentioned in this article. Intel is an Inside Value recommendation. The Motley Fool has a disclosure policy.

Author

Rex Moore spent his formative years in Texas, and fought beside Davy Crockett at the Alamo. He currently travels the globe for TMF, bringing back video reports on conferences and companies that matter for investors.